ECB Unlikely To Be Certain About Reaching Terminal Rate, Lagarde Says

27 June 2023

By Xavier D’Arcy – SINTRA, Portugal (Econostream) – The European Central Bank will likely keep the door open to further hikes rather than announce an end to its tightening cycle, due to uncertainty surrounding the persistence of inflation, ECB President Christine Lagarde said on Tuesday.

In a speech at the ECB Forum on Central Banking, Lagarde repeated that the ECB was likely to hike again in July, and said it was too early for the central bank to declare victory over inflation.

The ECB faced ‘uncertainty about the persistence of inflation’, which meant that ‘the level at which rates peak will be state-contingent’ and would ‘have to be continuously re-assessed over time’, she said. ‘Under these conditions, it is unlikely that in the near future the central bank will be able to state with full confidence that the peak rates have been reached’, she commented.

She told attendees at the ECB’s annual conference that the ECB’s job was not done, and barring ‘a material change to the outlook, we will continue to increase rates in July.’

‘[W]e cannot waver, and we cannot declare victory yet’, she added.

One of monetary policy’s key goals was to dampen demand to ensure that firms were no longer able to pass prices rises on to consumers, but to nonetheless allow real real wages to rise she said: ‘If monetary policy is sufficiently restrictive, the economy can achieve disinflation overall while real wages recover some of their losses.’

This hinged on ECB ‘policy dampening demand for some time so that firms cannot continue to display the pricing behaviour we have recently seen.’

There were significant upside risks to inflation if firms tried to defend their margins, she said: ‘If firms were to regain 25% of the lost profit margin that our projections foresee, inflation in 2025 would be substantially higher than the baseline – at almost 3%’, she said.

‘[F]aced with a more persistent inflation process, we need a more persistent policy’, she argued, 'one that not only produces sufficient tightening today, but also maintains restrictive conditions until we can be confident that this second phase of the inflation process has been resolved.’

The ECB needed ‘to carefully evaluate the strength of policy transmission in order to avoid an error in calibrating policy in either direction’, with evidence showing uncertainty over the effect of hikes on the real economy, she said.

It was possible that the services sector might be ‘insulated from the effects of policy tightening for longer than in the past, given the strength of demand and employment in the sector’, she noted.

For households, she said, there was ‘evidence that it will take longer for policy changes to pass through to interest burdens in this tightening cycle, as a higher share of households have fixed-rate mortgages than in the mid-2000s.’

How strong transmission turns out to be in practice would ‘determine the effect of a given rate hike on inflation, and this will be reflected in the expected policy path’, she said. Uncertainty about transmission was due to the fact that ‘the euro area has not been through a sustained phase of rate hikes since the mid-2000s and has never seen rates rise so quickly.’